Debunking the 80% Income Replacement Rule

By Chip Castille | August 24, 2014 AAA

Today I’m going to take a look at the 80% rule, which suggests that pre-retirees create a savings plan that will replace 80% of their income when they retire.

Let’s begin with a thought experiment: Imagine if you knew exactly how long you were going to live, when you were going to retire and how much you were going to make during your career. In such a highly certain world, odds are your retirement savings strategy would be pretty straightforward.

To illustrate one approach, the chart below assumes a twenty year lifespan, with retirement after ten years and a salary of $2.00 per year. It also assumes there is no inflation and no opportunity to earn an investment return.

Chart 1

In this example, we would save $1 of our $2 salary every year, leaving $1 to spend. Our wealth would accumulate steadily for ten years and peak at retirement. That would leave us with $1 to spend per year over the remaining ten years of the lifecycle.

On the simplest level, this thought experiment clearly illustrates that retirement spending is simply spending deferred. Spending more than $1 per year during our career would directly reduce spending in retirement. More subtly, it clarifies the true goal of retirement saving: maintaining a consistent standard of living.

By saving a dollar and spending a dollar, the blue bars – the spending level – remain consistent throughout the lifecycle. But what if our saving behavior was driven by a rule of thumb unrelated to our income and spending level? The next chart shows what happens if we were to apply our experiment to the 80% rule.

Chart 2

We would have to put aside $1.60 per year, leaving only $0.40 in spending during our career, drastically reducing our lifestyle. Our spending would then quadruple in retirement, leaving our pre and post-retirement spending seriously out of balance.

Clearly, we live in a very different world than the one represented in the charts. We face uncertainty about the length of our retirement, our career earnings and the return on financial assets. But I think our experiment does suggest that the goal of retirement savings should be achieving or maintaining a steady spending level.

In a sense, that is what we are already trying to achieve. The problem is that when it comes to our retirement savings, we tend to look at our accumulated wealth with little thought for how that translates into retirement spending. Whether you use online calculators (such as here or here) or work with your advisor on a drawdown strategy, the sooner you begin to focus on how to maintain a consistent spending level, the smoother the transition into retirement can be.

There are other issues about the 80% income replacement guideline. I will return to them in my next post.

 

Chip Castille, Managing Director, is head of the BlackRock US Retirement Group.  You can find more of his posts here.

?feed-stats-post-id=17943Investopedia and BlackRock have or may have had an advertising relationship, either directly or indirectly. This post is not paid for or sponsored by BlackRock, and is separate from any advertising partnership that may exist between the companies. The views reflected within are solely those of BlackRock and their Authors.

 

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